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Tuesday, 27 March 2012

The Australian economy

Australia has benefited hugely as the rise of China boosted the value of its commodity exports to stratospheric heights, gifting the country with mountains of cash.

But years of living off the fat of the land have left the economy of the so-called "Lucky Country" flabby and unproductive, ultimately threatening to crimp living standards while fuelling inflation.

Now that it seems the terms of trade can go no higher, policy makers are scrambling for ways to revive productivity or face years of slower growth ahead. The challenge was recently laid out in stark terms by the Treasury's top civil servant.

"We have maintained the same rate of growth in living standards only because of the huge rise in our terms of trade," said Treasury Secretary Martin Parkinson.

"If, as we suspect, the terms of trade are unlikely to grow much, if at all, from here, this means that growth in Australian living standards will also slow unless productivity picks up."

Almost all of Australia's growth in national income came from productivity in the 1990s, but over the past decade its contribution has more than halved.

Reserve Bank governor Glenn Stevens has also been bemoaning the paucity of productivity, even while acknowledging that there is very little monetary policy can do about it.

Productivity essentially determines the speed limit of the economy - how fast it can grow without generating unacceptable levels of inflation.

What worries Mr Stevens is that if productivity does not improve, interest rates will have to be higher than otherwise to keep inflation tame.

Exactly why productivity has waned is still something of a mystery, but economists suspect the windfall from the terms of trade meant many companies simply didn't have to work hard to be more profitable.

BHP Billiton, for instance, boasted a 62 per cent jump in earnings to $US31.9 billion for the year to June 2011, but all the increase came from higher commodity prices. Rising iron ore prices alone were worth $US11 billion in extra earnings.

That could be one reason productivity growth in mining has been among the worse of any industry in recent years. For 2011, gross value added per hour worked in mining fell 14 per cent, even as it rose 2 per cent across the economy.

Terms of trade hit ceiling

When the terms of trade, or the ratio of export prices to import prices, peaked last year it represented an annual income boost of between 12 to 15 per cent of Australia's $1.4 trillion in gross domestic product (GDP).

But while the terms of trade have doubled since 2003 and gross national income climbed 78 per cent, GDP per hour worked rose just 8 per cent, a third of the gain of the previous decade.

And now it looks likely the terms of trade have finally found a ceiling, having fallen 4.7 per cent in the final quarter of last year.

That had an immediate impact on measures of national income and nominal GDP. Real net national disposable income, a favourite marker of well-being for statisticians, fell 0.9 per cent last quarter, again the largest drop since 2009.

Nominal, or current price, GDP grew just 0.5 per cent - there have only been four weaker quarters in the past decade.

The latter is telling as changes in the terms of trade have an outsized effect on nominal GDP, which in turn feeds through to profits, wages and tax receipts.

To illustrate, since early 2003 nominal GDP has risen no less than 82 per cent while real GDP has increased 29 per cent. So even a flattening in the terms of trade point to much leaner times ahead.

Hence the intensified focus on productivity by policy makers. The centre-left Labor government plans to use billions in dollars of revenue from a new, and hard-won, mining tax to pay for skills training and infrastructure.

It has also embarked on a $36 billion project to build a fibre-optic based national broad band network, easily the most radical state-led telecoms plan of any developed nation.

The Liberals have tended to favour "labour flexibility", usually short-hand for weakening union power and making it easier to hire and fire people.

But the Howard government fell from power in large part because of its tough new labour laws in "Work Choices'', and seems reluctant to revisit the subject.

In the end, productivity cannot be mandated by government.

"There is a tendency in community discussions to think of this as a very nice, soft, wonderful concept and that we can just dial it up," said the RBA's Stevens recently.

"But it actually does not work that way; it works by firms, managements and work forces grinding out difficult changes to the way they do things every day."

No pain, no gain

Still, Mr Stevens also sounded optimistic that these painful changes were underway, in part because a high Australian dollar is forcing many firms to restructure or die.

With the currency near generation highs against a range of counterparts, sectors from manufacturing to retail and tourism are under intense foreign competition.

It was notable that productivity in manufacturing jumped 8 per cent over 2011, when measured by gross value added.

There is also good reason to believe that the woeful productivity performance of the mining sector will prove a temporary phenomenon.

While investment in the resources has boomed to record heights, many of the projects won't actually produce anything for years to come.

The $US34 billion Ichthys liquefied natural gas project, for instance, got final approval in January but will not produce a drop of gas until the end of 2016. In the meantime, a lot of work will be done seemingly with no output, artificially depressing standard measures of productivity.

In all there are eight major LNG projects underway worth a total $180 billion, which will more than triple output by 2016. Annual export earnings could easily hit $45 billion by 2015, up from $11 billion now, and reach at least $70 billion by 2020.

Likewise, Australia's output of iron ore is expected to rise by half in the next five years, with coal up by one-fifth.

As a result of all this new output, even a sharp correction in commodity prices might not necessarily undermine Australia's trade position, argue analysts at UBS.